REQUIRED READING: If you are working in default servicing or loss mitigation and feel like you are at the center of the proverbial bull's eye, you are right on the mark. From default and foreclosure management, ‘robo-signing’ issues and the related actions and proposed settlement from the state attorneys general, to potential regulations under the Dodd-Frank Act and the Consumer Protection Financial Bureau, servicers and loss mitigators are, to understate the case, facing unprecedented challenges.
Complicating matters is the fact that mortgage fraud perpetrators have shifted the focus of their schemes to the areas with the greatest return in today's environment: distressed borrowers and properties. As a result, servicers and loss mitigation departments that have never been tasked with spotting or stopping fraud must now be prepared to do both – or risk serious consequences.
The fraud-risk environment is especially dicey now because the federal government is so heavily involved in residential mortgages, whether directly through Federal Housing Administration insurance or incentive payments under the Home Affordable Foreclosure Alternatives program, or indirectly through the conservatorships of Freddie Mac and Fannie Mae. Lenders and servicers that fail to spot these schemes, or close the transaction despite "red flags" indicating possible fraud, risk financial liability to their investors and insurers and, where federal funds are involved, the possibility of becoming a defendant in a False Claims Act (FCA) suit.
This is not an idle threat: The Federal Deposit Insurance Corp. has already started to use the FCA to recover losses incurred from loans originated during the boom. Also, published reports speculate that the U.S. Department of Housing and Urban Development may be considering the use of this powerful tool as a result of unfavorable audit results, and field reports indicate that current regulatory/supervisory audits are focusing on quality-control programs and procedures relating to default servicing. To mitigate these substantial risks, servicing and loss mitigation personnel must be trained to recognize schemes, and effective action plans must be developed to protect against these risks.
The abundance of defaulting and underwater borrowers and large inventories of foreclosed properties provide plentiful opportunities for fraud. The primary schemes include the following:
Realtor-directed schemes. Reduced sales volumes and the need to generate income may explain why schemes directed by real estate agents are on the rise, especially in the context of short sales. The most frequent issue is the agent's undisclosed relationship with the buyer, whether it be an individual who promises additional listings for "playing ball" or offers kickbacks, or whether it be a corporation in which the real estate agent (or his or her broker, or friend) has an ownership interest. Real estate agents may also be active participants in flopping schemes.
Flopping. This occurs when the short sale price is fraudulently decreased in order to increase the profit margin on the subsequent resale. Because the valuation on short sales is usually determined by a broker price opinion (BPO), unethical real estate agents may manipulate the price by using inappropriate comparables, fabricating comparable sales, representing listing prices as sales, or misrepresenting the character and condition of the property. Agents have also manipulated prices by listing the property in the wrong city or neighborhood, marking the listing as being under contract when it is not in order to deter legitimate offers, or withholding higher offers from the lender or servicer.
Perpetrators may inflict cosmetic damage to the property, exaggerate the cost of needed repairs or claim that the property was, say, used as a methamphetamine lab when it was not. Finally, perpetrators often, prior to negotiating the short sale, identify an end buyer who is willing to purchase the property at a higher price but fail to disclose that fact to the servicer. It is the misrepresentation and omission of material facts that make these transactions fraudulent.
False liens. These are used in post-short-sale transactions as a means to direct proceeds from the end buyer's purchase into the perpetrator's pocket. They may be filed by a company with an undisclosed relationship to the buyer or by a foreclosure rescue/loan modification company. Red flags should be flying if liens on a property are filed after a notice of default or just before the short sale closes, especially if the lien holder readily agrees to accept a lower payment.
Foreclosure-rescue schemes. These schemes often represent the acquisition phase of a short sale or flipping scheme. Distressed borrowers may be induced to sign title to the property over to a trust that names the perpetrator as the trustee on the pretext that this is necessary to allow the trustee to negotiate a loan modification on their behalf. The property may then be sold out from under the borrowers, the perpetrator may not negotiate with the lender/servicer at all, or the perpetrator may misappropriate mortgage payments that are entrusted to him or her, with the end result being that the property is foreclosed.
Debt-elimination schemes. This is a foreclosure-rescue variant. Sovereign citizens and other groups claim that because no actual money changed hands, the note and mortgage are illegal. The perpetrators will send a packet of papers alleging the illegality of the note, a rescission of the power of attorney that allows the lender to foreclose, and a demand that the lender/servicer file a satisfaction or cancellation of the mortgage within 10 days. Since these claims are ludicrous, the paperwork is usually ignored. The perpetrators then file a forged cancellation or satisfaction to give the appearance that the borrower owns the property free and clear. The borrower then refinances the property and splits the proceeds with the perpetrator, and the process may be repeated.
Forced modifications. This occurs when a friend, relative or co-worker of a distressed borrower arranges a short sale and then reconveys the property to the borrower at the reduced price.
Loan modification schemes. Borrowers may misrepresent economic hardship or their income (some have filed fraudulent tax returns that are amended after the transaction closes), the value of the property, or occupancy status in order to obtain a loan modification for which they are not qualified.
Closing table frauds. Settlement agents may forge approval letters, disburse funds to parties that are not shown on the approved HUD-1 form, abscond with settlement funds, or fail to record short sale deeds in order to hide the price and the identity of participants.
Internal frauds (skimming and kickbacks). Servicer and loss mitigation personnel involved in short sale transactions may report a lower price to the lender after having negotiated a higher price with the buyer. The difference is then skimmed by the employee. In other cases, parties involved in the short sale kickback part of the proceeds to the employee in order to induce a favorable decision on a deflated short sale price. Employees who have production quotas, or who receive volume incentives, are particularly susceptible to these schemes.
Developing an action plan
Given the millions of borrowers who are already in default, and the millions more who are underwater, default-related fraud schemes are likely to increase for the foreseeable future. While the excess loss on an individual short sale may be small, in the aggregate and over time, the losses are likely to be substantial. An aggressive action plan can mitigate the risk of loss and civil liability. The following represents recommended steps that mortgage professionals can take:
- Review audit and production reports to identify patterns of suspicious activities based on losses, participants and exceptions; keep a scorecard on the participants.
- Review the file pre-closing to identify red flags and variances. This type of review requires verifying that the preliminary HUD-1 was prepared by the lender/servicer and not one of the participants, as well as verifying that the property was exposed to the market appropriately (i.e., verifying the property was listed on a Multiple Listing Service (MLS) and verifying that the listing was accurate in terms of describing the property and its location). The person or team conducting the review should look for any efforts to discourage potential buyers, such as the phrase "listing is exclusive to office" or a pending-sale date that is proximate in time to the original listing date. Reviewers should also verify that the agent's MLS number is valid and that it belongs to that agent. Furthermore, a pre-closing file review should compare the BPO value against an automated valuation model or other independent valuation source, confirm that the homeowner is aware of all the terms and conditions of the sale, and verify the short sale price with the settlement agent. (Approval letters have been changed by perpetrators to reflect a lower price.) Make sure the seller and buyer names as shown on the HUD-1 match the sale contract on file and on the contract given to the settlement agent, and check all parties against internal and government-sponsored enterprise watch, exclusionary and debarment lists. Also, search for businesses affiliated with the seller and the real estate and settlement agents.
- Require that all participants (including settlement agents) sign an affidavit attesting that there are no undisclosed relationships between them or any entity involved, and that the property has not been offered, shown or put under contract to an end buyer. (If it has, determine the resale price and then contact the end buyer's mortgage lender.)
- Where the buyer is a limited liability company, require an affidavit that lists the names, titles, phone numbers and addresses for its manager, members and any other persons or entities with a financial interest in the company.
- Prohibit settlement agents from closing short sales where they know, or have reason to believe, that there is another transaction pending for the same property unless they provide written notice and receive express written authorization to proceed.
- Post-closing reviews should be used to identify schemes. Although some losses may be unavoidable, post-closing reviews can identify persons and companies that should be placed on watch and exclusionary lists to limit additional damage. These reviews should include sample closed transactions and subsequent sales of the property. (Resales occurring 90 days or less after the short sale with significant price increases should be pulled for a full file review.) File reviews of suspect transactions should be undertaken to identify red flags and indicators that can then be used to improve pre-closing reviews and due diligence. Servicing and collection notes should also be reviewed for additional insights, and participants should be noted and placed on watch or exclusionary lists, or referred to law enforcement agencies, as deemed appropriate. If employees are involved, they should be monitored, re-trained, terminated or referred to law enforcement agencies, as deemed appropriate. If fraud is suspected or confirmed, a suspicious activity report should be filed. Also, investor agreements should be reviewed to determine if reports must be filed with the investor as well.
Knowing whom you are doing business with is a critical part of the solution to taming fraud risk. Scorecards that track participants and vendors in suspicious transactions can help identify dishonest actors. Automated tools that track participants, especially those that use years of historical transactions and data from multiple lenders, are particularly useful here.
If an in-house program is used instead, parties that should be tracked include buyers, real estate agents (listing and selling agents), settlement agents, lienors, all corporate entities associated with the participants, and employees.
Quality control should be independent of servicing operations. Effective quality control requires that employees receive training to recognize fraud schemes, the development of policies and procedures to close operational gaps and reduce instances of fraud, exception reporting and pipeline surveillance for clusters of high-risk transactions, protocols for determining acceptable sales prices that consider buyer credits/payments to the seller and money left on the table, and escalation protocols for confirmed fraud cases. Once the plan has been developed, a sampling of production should be used to test for results and adherence to the plan to make sure it is working.
The steps needed to control fraud may appear daunting, but sophisticated automated tools that do much of the legwork are available and have been successfully used in originations for years. There are also services that provide repurchase, insurance and valuation reviews; underwriting, investor guideline adherence and credit decision analyses; and loss recovery. While these tools and services do come with some costs, the government's attention to data quality and willingness to use civil and criminal suits to enforce appropriate due diligence make such tools and services an increasingly attractive and cost-effective solution. Adopting preventive measures now is the best way to move out of the center of the bull's eye.
Ann Fulmer is vice president of business relations for Agoura Hills, Calif.-based Interthinx. She can be reached at firstname.lastname@example.org or (703) 243-1019.